The Most Important and Misleading Assumption in the World

Part one of this blog post explained how macroeconomic models are flawed in a fundamental way.

These models are coupled to models of the Earth’s natural systems as Integrated Assessment Models (IAMs) that are used to inform climate change policy. Most IAM results presented in the Intergovernmental Panel on Climate Change (IPCC) reports show climate mitigation costs as trivial compared to gains in economic growth.

The referred to “elephant in the room” (from part one of this series) is the fact that economic growth is usually simply assumed to occur. No matter what the quantity or rate of investment in the energy system or the level of climate damages, the results indicate that economy will always grow. This defies intuition, and begs the question: If the costs of climate mitigation really are so small, then why is there so much disagreement over a low-carbon transition?

One way to explain the problem is via a term called “total factor productivity,” or TFP. TFP is the Achilles Heel of macroeconomics, and why no one talks about the aforementioned elephant with the exposed heel in the macroeconomics classroom.

Essentially economic output, or GDP, is usually modeled as being dependent upon the amount of labor in the workforce, the amount of capital (e.g., factories, machines, computers, buildings), and TFP.

TFP can be understood as all of the reasons why the economy grows that are not already characterized by the quantity of labor and capital. In statistical terms it’s called a “residual,” or the amount unexplained by an assumed underlying equation of economic growth.

TFP is often projected to continue (based upon trends from historical rates) at around 1.5 percent annually. Because labor and capital change relatively slowly (aside from events such as wars, a quick rise in sea level, or other similar “events”), this TFP assumption effectively assumes a large amount of growth into the future.

Further, the assumption of a historical annual rate of increase in TFP is inherently independent of energy-related factors (see IPCC report “Climate Change 2014: Mitigation of Climate Change”). Thus, the normal IAM assumption is inadequate because it presents the case to policy makers that even dramatic increases in energy investment for a low-carbon energy transition don’t affect TFP and hence economic growth.

This is a problem since it makes the transition appear trivial. It’s incorrect, however, to assume TFP will continue into the future just as it had in the past because the past was a time of increasing carbonization of the economy. It is too much of an extrapolation to assume TFP will be the same during decarbonization.

But there is a solution.

A significant body of research indicates that accounting for both energy and its conversion efficiency to physical work (e.g., engines and motors) and other energy services (e.g., light) can explain the vast majority of TFP. That is to say, instead of assuming an increase in TFP into the future that is independent of the modeled energy technology investments, we could assume a series of low-carbon energy technology investments and estimate the effect on TFP, thus economic growth, from the bottom up.

TFP is effectively composed of the effects of machines and energy substituting for human labor. A human pushing a button on an electrified machine is more “productive” than that human turning a crank by hand on that same machine.

Part of the reason why TFP, and its cousin labor productivity (= economic output / hour of labor), have been decreasing in the last decade is due to declining energy consumption and slower improvements in efficiency. There are still a lot of low-hanging fruit, however, we already picked the ripe fruit that fell to the ground. And, it still takes effort to pick even the low-hanging fruit. There is no free (fruit) lunch.

Aside from a need to develop more accurate macroeconomic models that explicitly account for the role of energy, there is a larger concern in regard to sustainability. The modeling improvements discussed in this post relate to the economic and environmental (e.g., climate, energy) pillars of sustainability.

Existing models, however, also inhibit discussion of equity, the third pillar. If we convince ourselves that we will always grow in the future, no matter what, then we can more easily convince ourselves that we can defer the question of sharing until the future, until after we’ve figured out growth for now.

This is exactly why the exogenous TFP assumption is socially dangerous.

The models simply assume economic growth occurs. Then, since everyone is convinced that the world is going to have more wealth to share in the future, no matter what, then we can avoid discussions about sharing and preserving what we have now. We can deflect the conversation to “growth” instead of the “equitable” part of sustainability. “Help us grow the economy first, and then we can fix the other issues.”

That said, we know a number of things for certain.

The Earth is finite, and we know we cannot have infinite growth on a finite planet. Thus we need physical and economic models that also reflect this reality. Unfortunately, we’re using economic models that ignore this reality. Why should we make policy using economic models that don’t reflect what should be obvious to a third-grader?

We can do better, and we must do better if we want realistic economic assessments of a low-carbon energy transition. If we don’t want realistic assessments, then we can continue the status quo, which is to explain the future economy by projecting a factor (i.e., TFP) defined as what cannot explained by insufficient theory.